HONEYGUIDE IN THE NEWS

Many who work in oil saw the opportunities available during the downturn in oil and gas. In this article in Bloomberg, you'll read how some have struck great fortune by taking advantage of them. There is also mention of a number of firms who take the same approach as Honeyguide.

Taxes can have a real impact on any investment opportunity and the forms that exists on any specific investment can vary. According to Turbotax.com, the Schedule K-1 is, “the form that reports the amounts that are passed on through to each party that has an interest in the entity”.

Businesses that operate as partnerships, like Honeyguide, are designed to use pass-through taxation, which means that all income and expenses pass through the corporation to the owners and partners. This is a good thing! Depletion incentives, intangible and tangible drilling expenses, and the favorable capital gains rate paid at sale are big advantages when investing in private oil and gas.

The K-1 is a tax form that all investors in Honeyguide will receive indicating their share of income, losses, deductions, credits, and distributions made during the year. The investor then reports this information on their tax return.

If you have invested in real estate in the past, you will have familiarity with the K-1. Remember that what is reported from our K-1 can be accounted for alongside any other K-1’s you may be filing in taxes.

If you are new to oil and gas investing and want to view a sample K-1 report, here is one that is populated as if it were completed. Granted, the form is from 2009, but it still provides an idea of what to expect should you enter into an investment. Also, you can print this out and have your accountant explain in detail how this may positively impact your investment portfolio.

Ok, let me rephrase that. What are waterfalls in the realm of private equity? In this article, we’ll review waterfalls, clawbacks, and catch-up clauses and how they pertain to investors. Each have their own unique importance in private investing and define how distributions flow from the investment to the partners and the terms of the manager’s performance fee.

When investments provide a return and cash needs to be distributed, the waterfall defines how these funds are allocated. The preferred return can range usually between 6-9%, and is defined as 100% of funds going to investors until this return is reached. It is after this return hurdle is reached that funds are distributed between investors and the manager – usually at 80% to investors and 20% to the manager. Usually there will be another higher return hurdle that needs to be reached in order for cash distributions to split even further. Waterfalls are useful for aligning interests amongst investors and managers. By incorporating a preferred return, it ensures that managers must find appropriate investments that will bring a robust return in order to get paid. Meaning, only once investors make their return, then managers can participate in profits. Honeyguide utilizes a preferred return.

Honeyguide also uses a European waterfall vs. an American waterfall. In European waterfalls, 100% of the investment cash flow is paid out to the investors on a pro rata basis until the preferred return is reached. Pro rate means that all capital is treated equally, and distributions are paid out proportionately to the amount of capital invested. Once the return hurdles have been satisfied, then the manager’s portion of the profits is realized.

In an American waterfall, the manager can receive an incentive fee on each deal, even if the investor’s preferred return and capital have not been paid back in full. The intent here is to help a smaller manager with their income over the life of the fund. When looking at private investments, this is something that should be looked for in the Private Placement Memorandum (PPM). At times, this kind of waterfall may be more suitable when the end goal is to hold the asset for income and there is little risk to the principal. In these instances, however, managers participate in the income stream from the first day.

With American waterfalls, it’s important to have a feature called a clawback clause. This entitles investors to get paid back any incentive fees taken by the manager in an instance where the investment underperforms. Because Honeyguide uses a European waterfall, no incentive fees are taken upfront.

A catch-up clause is meant to make the manager whole so that their incentive fee is a function of the total return and not just on the return in excess of the preferred return. For example:

Without Catch-up ClauseThe investor would receive an annualized preferred return and their capital back.Then all remaining distributions would be split 80% to investors and 20% to the manager.

With Catch-up ClauseThe investor would receive an annualized preferred return and their capital back.The manager would then receive 100% of distributions until they get 20% of all annualized profits (catch-up clause).Then all remaining distributions would be split 80% to investors and 20% to the manager.

You can now see how each of these tie together starting with the waterfall. The waterfall will tell you where you stand in the allocation order. From there, you’ll want to know if there is a catch-up in place. The catch-up will dictate whether the fund manager is made whole prior to a profit split. Lastly, understand if there is a clawback clause. Having one in place can help investors recoup additional funds in the event the fund manager gets a deal by deal incentive fee found in American waterfalls.

​A recent report from McKinseyalthough we've had fantastic performance in the market, investment returns are likely to come back down to earth over the next 20 years.

Oil and gas investments can decrease volatility and increase returns when added to your current portfolio of stocks and bonds. Even more substantial to this thesis is the fact that commodities are a good investment during a recession as demand is not purely driven by the U.S. economy, and commodities are traded on a global basis.

It’s important to know the many types of oil and gas investments you can make because each one will have an impact on your overall portfolio. Recently we had an investor ask us why they should buy into a Honeyguide Fund instead of the public markets or a public oil and gas royalty trust?

While investments in the public markets have a lot going for them such as, a proven long-term record, a dividend yield, and liquidity, the answer isn’t “either-or” but rather “and”. These are different types of investments and both can be beneficial to your portfolio.

Private Equity Is Not Tied To Certain Elements Found In Public MarketsThe most popular method for investors to introduce oil and gas into their portfolio is through oil and gas stock or a royalty trust. This is certainly an effective way to gain exposure, however, it has a relationship to the stock market.When the overall stock market begins to contract, your holdings could begin to experience negative pressures from investor sentiment in the market. With private equity, however, there is less volatility due to the significantly lower number of outside forces pressuring a sell off. Also, in private equity, many people are investing for the long term thus keeping the investment stable and resistant to investor fear volatility in liquid markets.

A Reduction In Risk ExposureWhen investing in the stock market, it can take quite a bit of energy and research to compile a diversified portfolio. You may want tech exposure in your portfolio but purchasing one tech stock will not give you the proper diversification within that sector.

Private equity funds can offer exposure to a certain portion of the market while offering diversification. Many funds achieve diversification by investing in multiple opportunities that meet their specific investment criteria and mandate. This provides overall risk diversification, while gaining exposure to a particularly focused part of the market – in our case, lower-risk oil and gas equity investments.

Consider Whether Incentives Are AlignedWe started Honeyguide after seeing that there were limited options for us to invest in private equity oil and gas. The industry commands that you have hundreds of millions of dollars to make purchases. The opportunities to retail investors are not led by technically experienced personnel, and they usually place most risk on the investor. At Honeyguide, the manager’s do not make any profit until the investment pays itself back plus brings investors a return. You will be hard pressed to find an investment vehicle such as this in the public markets.

Is private equity oil and gas a part of your portfolio? With its inverse correlation to bear markets, robust returns and managed risk, it can prove to be an essential part of your portfolio.

​With private equity, investors look at the internal rate of return, or IRR, to help gauge their potential earnings. According to Investopedia.com, the IRR is defined as “…a metric used in capital budgeting to estimate the profitability of potential investments”.

While using the internal rate of return can be useful, if utilized incorrectly or without the proper context, this data point can be misleading. A simple example would be looking at three different investments with three different IRR’s. You may think that the best investment has a high IRR compared to the others, but without knowing your required rate of return, or RRR, you may be making a misjudgment.

For instance, if you invested $10,000 in year 1, and then received $5000 in the consecutive year 2, 3, and 4 – your IRR would be 23.3% over the three years. The investment’s gain was 50%. On an annualized basis, this investment would need to generate 14.4%. So if you invested $10,000 that gained 14.4% annually, the investment would then be worth $15,000 in three years, providing you a total 50% return on invested equity. This is not the same as if you invested $10,000 that gained 23.3% (our calculated IRR). This would result in a much higher final gain than indicated by the initial prompt.

As you can see, IRR need not be confused with annualized return rate. Furthermore, IRR alone will not help in creating wealth. If you considering an investment into private equity, make sure to determine how much wealth was created by looking at other metrics as well – not just whether a high IRR was reached.

The positives of IRR, however, are that getting cashflow earlier can be better in the fact that this reduces risk (versus cashflows that happen far out into the future). Thus a higher IRR, will help ascertain this risk.

But at the end of the day, remember IRR and annualized returns are different – albeit many investors equate them to the same thing. When looking at a private equity investment, be sure to consider all metrics including IRR and annualized returns. Ensure that the private equity firm is helping you obtain real wealth.

​​For those familiar with the stock market, you likely know of the annual reports and SEC filings such as 8-K and 10-K. These are the documents that allow an investor to become familiar with the company. The PPM, short for Private Placement Memorandum is a private offering document not offered to the public at large. By definition, private investment opportunities are not public offerings. The PPM is used by investors to become familiar with the terms of the private investment opportunity.

Reviewing the PPM is an important part of the due diligence process. Most investors rely on a referral from another investor or a friend, just the marketing materials alone, or after a phone call with the manager. Generally, this is an okay strategy. However, it’s when a manager doesn’t do what they says they’re going to do and an investment goes awry that every word in the PPM comes under scrutiny.

Let’s help you look at a PPM.

There is likely to be a summary in the beginning that spells out many of the high points investors want to hear about. You may see information regarding documents, a brief company bio, and any information relating to fees you might incur investing. This won’t tell you everything, but it will be a good place to get you started.

From there, the document may go into management and further detail about the company. If you are unfamiliar with the company, this is where you will want to spend some time. As an investor, you will want to look at management and who is on the executive level. Even further, you’ll want to see their bios and how much experience they have. Should there be any issues with the company, these are the individuals tasked with eliminating the issue.

Further into the private placement memo, you will tend to find something along the lines of an investment strategy and principal terms. This information will tell you, the investor, how the company or fund will operate to generate your desired returns. Here is where you will really want to get into the detail and understand the end game. The principal terms will outline what investors pay, they expenses the company will bear, how profits are split and more. In a ranking of your decision-making, this section is near the top, if not the highest. You will likely know if this is a solid investment opportunity from this section, depending on if the details are laid out well.

Lastly, you will find a section that details the risks of the investment. For those of you familiar with stocks, this is typically in the first section of the annual report. Though it can be lengthy, it is important to understand many of the internal and external risks that can influence your investment returns. No matter how well versed you are with risks in this industry or another, it is important to review possible risks. Similar to the investment strategy, this is a section that may determine your willingness to invest.

No matter the market or investment, it is critical to read up on every piece of information. In the private equity market, it typically means higher levels of investments, which means a greater need to research. While with a stock, you can invest down the price per share, with private equity, you are investing a 5 to 8 digit investment at once. The private placement memorandum is a great way to start, but if you have any questions, reach out to the company or fund and request more information. Odds are they are willing to explain or give you more information should you have any concern.

​Excerpt:Shale has unquestionably impacted global crude oil prices, quality mix, and trade flows. But shale is too small, too slow, and too competitive (if shale chief executives tried to collude, they would face prison) to play the swing producer role. Other than abhorring boom-bust price cycles, shale and swing producers share little in common.Looking ahead, shale is unlikely to sustainably grow enough to quench the world’s raging thirst for oil. Three years of lower oil prices have boosted demand, and the vaunted energy transition from oil to electric vehicles will arrive much later than advertised.A world economy growing at the nearly 4 per cent rate the IMF projects will require nearly 2m barrels a day of net supply growth per year, which means adding 4-5m b/d of new gross supply considering declines from existing fields. Even if shale grows 1m b/d annually, it will not unilaterally meet global supply needs.

Thus, barring an economic downturn, by early in the next decade the world economy will need but lack new oil production from longer-cycle conventional projects cancelled or delayed since the 2014 bust.

​With all the different ways to invest in the market, you can narrow them into one of two categories, public or private. An example of public investing would be stocks, exchange traded funds, and mutual funds. These are accessible to nearly everyone and are relatively easy to enter and exit. The underlying information such as financials and management are mandated by a governing body and are publicly available. Private investing, on the other hand, typically has an investment requirement that limits investors and will have principal terms indicated in a Private Placement Memorandum.

Breaking this down further, let us start with the accessibility. As previously stated, public securities are typically easy to enter and are usually free of initial investment requirements. Where you may see requirements are in the mutual fund space, but even though they are in place, the limits are usually accessible to retail investors. With private investments, these often require 5 to 8 figure initial investments and require the investor to have their money allocated for long periods of time.

Length of time invested can differ as well between public and private investments. For example, should you purchase a stock or ETF, you can enter and exit the position as you wish. Mutual funds may have a restriction on how often you can enter and exit, as these vehicles are not meant for trading. Private investing on the other hand tends to hold your investment for several years. The reason for this is your investment is likely to be used in funding asset purchases, which usually yield a profit only after a certain amount of time has passed.

Lastly, fees and return structures will vary significantly between private and public investment funds. While fee structures can tend to be lower with specific publicly accessible investment funds, the returns are determined by share price. In order for private investments to remain competitive, they too will offer low fees, but the return structure will be different. At Honeyguide, we offer a distribution waterfall. What this means is that investors receive profits first, with a preferred return, paying back the original capital invested. Only after this happens do we partake in any of the proceeds. This is one way of ensuring that incentives are aligned with the management team and investors money. The management team must make good investments in order to get paid.

With private investing, it may require a higher initial capital, but the risk and return can make it worthwhile. This can add diversification to your portfolio and add another layer of generated returns

"Our models tell us that global inventories will continue to draw and we run the risk of a huge upward move in prices starting right now” according to a report by Goehring & Rozencwajg. “We are being presented with the buying opportunity of a lifetime” in the energy sector.​“Global oil inventories continue to draw rapidly and we have now reached the point where further drawdowns will put severe upward pressure on prices. Oil production from the US shales has slowed significantly in the last six months . . . Despite continued rampant bearishness, global oil demand continues to significantly exceed supply and global inventories are now drawing at record rates.”

“As Chart 1 vividly shows, we are now drawing down global inventories at the fastest rate ever experienced. Readers of our letters will be familiar with the drivers of this rapid drawdown: global oil demand is surging, while non-OPEC oil supply (both here in the US and abroad) is disappointing . . . the inventories have now drawn down to critical points where further inventory reductions will result in severe upward price pressure.”

When this has occurred historically oil prices “surpassed $100 per barrel”.

Disclaimer: The information on this site is for general purposes only and is not a solicitation to buy or an offer to sell any securities. General information found on this site is not intended to be used as individual investment or tax advice. Consult your tax advisor concerning the application and effect on your individual tax scenario.